Warren Buffett: Growth Stocks Are Not Always the Best Option

Buffett on the difference between value and growth

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Jul 16, 2020
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What is the better investment, a company that's reporting explosive growth but having to keep reinvesting to keep the wheel turning or a business that's not growing and can return a lot of cash to investors?

Warren Buffett (Trades, Portfolio) took on this question at the 1994 Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) annual meeting of shareholders.

Growth vs. cash

Responding to a shareholder who asked the Oracle of Omaha about the discount rates he used to value growth businesses, Buffett said, "we are not looking at projecting numbers out, as to what kind of cash we think we'll get back over time."

Instead of trying to predict returns out into the future, he went on to add, Berkshire was looking for investments that had steady, predictable returns based on their current state:

"But you know, would you rather have something that paid you 10% a year and never changed, or would you rather have something that paid you 2% a year and increased at 10% a year? Well, you can work out the math to answer those questions."

He went on to add that "you can certainly have a situation where there's absolutely no growth in the business," and the opportunity is a much better investment that other companies growing at a break-neck pace.

As Buffett went on to explain, it all comes down to the amount of capital required by a business:

"There's a huge difference in the business that grows and requires a lot of capital to do so, and the business that grows, and doesn't require capital. And I would say that, generally, financial analysts do not give adequate weight to the difference in those. In fact, it's amazing how little attention is paid to that. Believe me, if you're investing, you should pay a lot of attention to it."

These sorts of businesses have been a feature of Buffett's Berkshire for decades. See's Candy is the perfect example. See's hasn't achieved fantastic growth over the past few decades, but the business has thrown off billions of dollars in profit. Buffett has taken this cash and invested it into other companies.

As Buffett explained in 1994:

"Some of our best businesses that we own outright don't grow. But they throw off lots of money, which we can use to buy something else. And therefore, our capital is growing, without physical growth being in the business."

Growth companies that consume a lot of capital might capture lots of headlines, but they don't create wealth until they mature. A rising stock price does not count as creating shareholder value - that comes with profits and expansion of shareholder equity. Many growth companies that rely on borrowing or share issues to keep the lights on do not meet this criteria.

Buffett's comments from 1994 are relevant for all investors. A business can be a good investment if it is not a growth stock. At the same time, companies do not always have to be chasing growth. If a company does something well and earns an attractive return on that good or service, there should be no need to risk losing customers or overextending by chasing new markets.

A classic example in Buffett's portfolio today is Coca-Cola (KO, Financial). Coke's sales have declined by around 15% over the past five years, so it's not a growth stock. Still, its near 50% return on equity means that the firm is still yielding a good amount of cash, the majority of which it can and does return to investors. Thanks to this, the stock has produced a total return of 8.5% per annum for the past decade. That's not a blow-out return, but it's a steady return from a predictable business.

Disclosure: The author owns shares in Berkshire Hathaway.

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